U.S. Public Pension Funds Trends in Investment & Reporting

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1 U.S. Public Pension Funds Trends in Investment & Reporting ICPM Discussion Forum October 2017 Greg Mennis, Director Susan Banta, Director of Research Public Sector Retirement Systems Project

2 The Pew Charitable Trusts More than 40 active, evidencebased research projects U.S. projects include public safety, pensions, and states fiscal health All follow a common approach: rigorous, data-driven, nonpartisan 2

3 Pew s Public Sector Retirement Systems Project Research since 2007 Includes 50-state trends on public pensions and retiree benefits relating to funding, investments, governance, and employee preferences Technical assistance for states and cities since

4 State Public Pension Funds Increase Use of Complex Investments Heavier reliance on alternatives yields mixed results, highlights need for increased transparency Findings: Only two of the funds examined exceeded investment return targets over 10 years. While these results still include the market downturn during , forward looking expectations are lower than historical results. The use of alternative investments has doubled over the last decade and tripled since 2000, although across public pension funds use varies widely. Funds with long-standing alternative investment programs focused on private equity and real estate are among top performers Funds with recent and rapid entries into alternative markets -- including significant allocations to hedge funds -- reported the weakest 10-year returns. There is a uniform need for full disclosure, including net of fee reporting and full disclosure of private equity fees. 4

5 Presentation Overview Background on the U.S. public pension system and introduction to Pew s stress test simulation model Review of Pew report: State Public Pension Funds Increase Use of Complex Investments (April 2017) 5

6 US Public Pensions Background State and local governments sponsor pension plans covering over 14 million active employees and 10 million retirees. Most states administer two large plans one for state government workers and one for teachers. Management of local plans varies by jurisdiction. Public pension plans are governed in part by federal regulations and standard reporting requirements. However, funding policies and legal protections for worker benefits vary from state to state. State and local governments report over 5 trillion in pension liabilities and a funded ratio of ~72%. Average discount rate is 7.4%. States and municipalities have adopted reforms to improve the sustainability of public sector retirement systems. But key measures indicate that in aggregate, public pensions are as vulnerable as ever to an economic downturn. 6

7 State and Local Pension Debt as a Share of Gross Domestic Product 14% 12% 10% State and local pension debt as a share of GDP spiked after the Great Recession and remains at a historically high level. 8% 6% 4% 2% 0% -2% -4% -6% -8% 7

8 Benefits and Contributions, $ Billions Ratio of Assets/Benefits Benefits, Contributions &Assets/Benefits for State & Local Plans Widening Operating Cash Flow Gap and Reduced Asset to Benefit Coverage $ $ $250 $ $ $100 $50 5 $ Assets/Benefits Benefits Contributions 0 Sources: U.S. Census Bureau Annual Survey of Public Pensions. 8

9 Rate of Return in Percentage Points, % Pension Fund Risk Premium at Historic High Plan s average assumed rate of return remains relatively stable, while bond yields have declined Treasury 30 Year Yield Avg. Assumed Rate of Return 9

10 Investment Returns Pension Fund Investments Track the Stock Market Equity investments and pension fund returns are highly volatile TUCS Federal/State DB Plan Median Performance (%) S&P

11 Key Fiscal Measures Funded Ratio: The ratio of assets to the accrued pension liability. Average discount rate on liabilities of 7.4%. Annual Required Contribution (ARC): Calculated by each state s actuaries using plan specific assumptions. New metrics and measures: o Net amortization: A benchmark to measure whether the ARC is sufficient to reduce the unfunded liability if plan assumptions are met. o Operating Cash Flow to Assets: A benchmark for investment performance to prevent assets from declining. o Stress Test Reporting: Five states have adopted so far. 11

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13 Stress Test Research Questions 1. How do we measure fiscal distress and which states are at risk? 2. How might lower investment returns impact pensions costs and therefore state budgets in the long term? 3. What is the impact of economic volatility on pension fiscal health, given states high exposure to stocks and other risky asset classes? Forthcoming Paper: Greg Mennis, Susan Banta, and David Draine, Assessing the Risk of Fiscal Distress for Public Pensions: State Stress Test Analysis, The Pew Charitable Trusts. 13

14 Stress Testing Simulation Model Foundational Structure Pew s simulation tool incorporates a state s financials as inputs, simulates economic conditions, and produces projections and metrics 14

15 Pew s Analytic Framework Two-part lens that helps generate broad range of likely outcomes 15

16 Key Findings from Stress Testing Reporting Economic indicators and pension fiscal metrics suggests that US Public pension funds are more exposed than ever before to an economic downturn. Under scenarios with lower investment returns, poorly funded plans project unfunded liabilities beyond a 30 year forecast period, and in some cases, insolvency within 20 years. States with well-funded pension systems have achieved this result through a combination of fiscal discipline and policies specifically designed to manage the impact of market volatility. Stochastic analysis reveals that differences in funding policies, rather than the sequencing of investment returns, is the primary factor influencing projected cost variability. Stress test analysis can help states to better plan for economic uncertainty and ensure that investment strategies are aligned with fiscal policy goals 16

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18 State Public Pension Funds Increase Use of Complex Investments Heavier reliance on alternatives yields mixed results, highlights need for increased transparency Scope Comprehensive data on the 73 largest pension funds across all 50 states, including asset allocation, performance and reported fees. Examination of the investment and reporting practices across state public pension funds. Deeper review of the use of alternative investments by public pension funds. 18

19 State Public Pension Funds Increase Use of Complex Investments Heavier reliance on alternatives yields mixed results, highlights need for increased transparency Data Sources Comprehensive Annual Financial Reports, pension plan actuarial valuations, and other U.S. state public pension plan documents, 2006 to U.S. Federal Reserve Financial Accounts of the United States, 1952 to Wilshire Trust Universe Comparison Service (TUCS), 1991 to

20 State Public Pension Funds Increase Use of Complex Investments Heavier reliance on alternatives yields mixed results, highlights need for increased transparency Findings: Only two of the funds examined exceeded investment return targets over 10 years. While these results still include the market downturn during , forward looking expectations are lower than historical results. The use of alternative investments has doubled over the last decade and tripled since 2000, although across public pension funds use varies widely. Funds with long-standing alternative investment programs focused on private equity and real estate are among top performers Funds with recent and rapid entries into alternative markets -- including significant allocations to hedge funds -- reported the weakest 10-year returns. There is a uniform need for full disclosure, including net of fee reporting and full disclosure of private equity fees. 20

21 Investment Allocation Investments More in Stocks and Less in Bonds Public pension investments, % 80% 60% 25%: Alternatives 40% 20% 51%: Equities 0% Equity and alternatives Fixed income and cash Sources: U.S. Board Of Governors of the Federal Reserve System, Financial Accounts of the United States, 1954 to 2014; Pew Analysis of State Financial Reports 21

22 Investments: Increased Use of Alternatives Share of pension assets in alternatives has more than doubled Alternatives 11% Alternatives 26% Fixed Income & Cash 28% Equity 61% Fixed Income & Cash 24% Equity 50% Sources: Analysis by the Pew Charitable Trusts of State Comprehensive Annual Financial Reports, Public 100, and the Federal Reserve Financial Accounts of the United States. 22

23 AZ PSPRS PA PSERS MO MOSERS UT URS PA SERS SC SCRS IL TRS OH PERS MI SERS MD SRPS MI PSERS WA DRS TX TRS VT TRS IN INPRS KY KRS MA SERS & TRB VT SERS OR ERS VA VRS IL SERS WV PERS AK PERS AK TRS WV TRS LA LASERS MO PSRS AZ ASRS NM ERB NJ DPB LA TRS SD SDRS CA CalSTRS RI ERS WY WRS AL ERS ND PERS ND TFFR OH STRS TX ERS AL TRS NC NCRS CA CalPERS IA PERS NY SLRS CT TRB AR TRS KS PERS MT PERB MT TRS DE PERS CT SERS ME PERS NY STRS WI WRS FL FRS CO PERA NM PERA OK TRS AR PERS NH NHRS HI ERS KY TRS IL SURS MI PERS MN MSRS, TRA, & PERA ID PERS NE NRS TN TCRS NV PERS GA ERS GA TRS OK PERS Percentage in Alternatives Alternative Investment Allocations for 73 Public Pension Funds Six in ten invest more than 20 percent of assets in alternatives 55% 50% 45% 40% 35% 30% 25% 20% 20% 15% 10% 5% 0% Sources: Comprehensive Annual Financial Reports, 2014; quarterly investment reports; and plan responses to data inquiries 23

24 Number of Funds Within Risky Asset Range State Pension Fund Allocations to Equities & Alternatives Most funds have between 70 and 80 percent of investments in risky assets <70% 70% < 80% 80% Percent Risky Assets Sources: Comprehensive Annual Financial Reports, 2014; quarterly investment reports; and plan responses to data inquiries 24

25 Investment Performance Pension Fund Investments Track the Stock Market Equity investments and pension fund returns are highly volatile 40% 30% 20% 10% 0% % -20% -30% TUCS Federal/State DB Plan Median Performance S&P

26 Investment Performance Pension Fund Investments Track the Stock Market Equity investments and pension fund returns are highly volatile 40% 30% 20% 10% 0% % -20% -30% CT TERF TUCS Federal/State DB Plan Median Performance S&P

27 Investment Performance Pension Fund Investments Track the Stock Market Equity investments and pension fund returns are highly volatile 40% 30% 20% 10% 0% % -20% -30% CT TERF NJ TUCS Federal/State DB Plan Median Performance S&P

28 Investment Performance Pension Fund Investments Track the Stock Market Equity investments and pension fund returns are highly volatile 40% 30% 20% 10% 0% % -20% -30% CT TERF NJ NCRS TUCS Federal/State DB Plan Median Performance S&P

29 Investment Performance Pension Fund Investments Track the Stock Market Equity investments and pension fund returns are highly volatile 40% 30% 20% 10% 0% % -20% -30% CT TERF NJ NCRS PA PSERS SCRS TUCS Federal/State DB Plan Median Performance S&P

30 Investment Performance Pension Fund Investments Track the Stock Market Equity investments and pension fund returns are highly volatile 40% 30% 20% 10% 0% % -20% -30% CT TERF NJ NCRS PA PSERS SCRS VRS TUCS Federal/State DB Plan Median Performance S&P

31 Investment Performance Pension Fund Investments Track the Stock Market Equity investments and pension fund returns are highly volatile 40% 30% 20% 10% 0% % -20% -30% CT TERF NJ NCRS PA PSERS SCRS VRS TUCS Federal/State DB Plan Median Performance S&P

32 Ten-Year Returns Reporting Net of Fees on a June 30 Fiscal Year (2015) Returns ranged from 4.7 percent to 8.1 percent Sources: Comprehensive Annual Financial Reports, 2015; quarterly investment reports; and plan responses to data inquiries 32

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34 Reporting Standards Have not Kept Pace with Increased Risk Make investment policy statements transparent and accessible Disclose bottom-line performance, both net and gross of fees Expand performance reporting to include 20-year results by investment type Include performance results by asset class both net and gross of fees Adopt comprehensive fee reporting standards, including Institutional Limited Partners Association (ILPA) recommendations 34

35 Reported Private Equity Fees by State Pension Fund Performance fees substantially higher than invoiced management fees 4.50% 4.00% 3.50% 3.00% 2.02% 2.50% 2.00% 2.06% 2.14% 1.50% 1.00% 1.80% 0.50% 1.03% 1.13% 0.00% South Carolina MOSERS CEM* Private equity management fees Private equity performance fees Note: *CEM figures for reported and estimated unreported PE fees, 2012 & 2013; CalPERS recent supplemental disclosure of PE performance fees also equaled over 2% of assets Sources: The Pew Charitable Trusts, SCRS and MOSERS Plan CAFRs, and CEM Benchmarking 35

36 Just How Much in Private Equity Fees Go Unreported? In 2014, state-sponsored plans held more than $250 billion in private equity (nearly 9 percent of assets). Estimated $4+ billion in undisclosed fees. In comparison, reported fees were $10 billion. 36

37 37 States That Have Adopted Stress Testing and Investment Fee Transparency Measures* AK WA VT NH ME HI CA OR NV ID AZ UT MT WY CO NM ND SD NE KS OK MN IA MO AR WI IL MS MI IN TN AL KY OH NY PA WV VA* NC SC* GA NJ MD MA RI CT DE Stress Testing Required Comprehensive Fee Reporting Required TX LA FL Both Considering *Note: South Carolina and Virginia also recently commissioned a 50 state comparative study of retirement benefits and policies

38 Aggregate Returns Stochastic Projection of 20-Year Investment Returns for Virginia Trials averaging 6.4 percent over 20 years show volatility of returns over time 400% Three Trials with 6.4% Returns (50th Percentile) 350% 300% 250% 200% 150% 100% 50% Trial 1 Trial 2 Trial 3 Note: Each line shows the total growth of a dollar in plan assets from investments. By 2036, in all three of the trials, that dollar value is projected to grow by 345 percent for an annual growth rate of 6.4 percent. Source: The Pew Charitable Trust and The Terry Group 38

39 20 Year Employer Contribution Rate Projected Impact of Volatility of Costs for Virginia and South Carolina Funding policy has a significant impact on the range of required contributions 30% Virginia 25% 20% 15% 10% 5% 0% 25th Pctl (4.8%) 50th Pctl. (6.4%) Expected (7%) Note: 20-year projected contributions at different returns Sources: The Pew Charitable Trusts and the Terry Group 39

40 20 Year Employer Contribution Rate Projected Impact of Volatility of Costs for Virginia and South Carolina Funding policy has a significant impact on the range of required contributions 30% Virginia 25% 20% 15% 10% 5% 0% 25th Pctl (4.8%) 50th Pctl. (6.4%) Expected (7%) Note: 20-year projected contributions at different returns Sources: The Pew Charitable Trusts and the Terry Group 40

41 20 Year Employer Contribution Rate 20 Year Employer Contribution Rate Projected Impact of Volatility of Costs for Virginia and South Carolina Funding policy has a significant impact on the range of required contributions 30% Virginia 30% South Carolina 25% 25% 20% 20% 15% 15% 10% 10% 5% 5% 0% 25th Pctl (4.8%) 50th Pctl. (6.4%) Expected (7%) 0% 25th Pctl. (4.5%) 50th Pctl. (5.9%) Expected (7.25%) Min Average Max Deterministic Note: 20-year projected contributions at different returns Sources: The Pew Charitable Trusts and the Terry Group 41

42 20 Year Employer Contribution Rate Projected Impact of Volatility of Costs for North Carolina and Wisconsin Risk-sharing provisions limit costs and volatility for Wisconsin 30% North Carolina 25% 20% 15% 10% 5% 0% 25th Percentile (4.6%) 50th Percentile (6%) Expected (7.25%) Note: 20-year projected contributions at different returns Sources: The Pew Charitable Trusts and the Terry Group 42

43 20 Year Employer Contribution Rate 20 Year Employer Contribution Rate Projected Impact of Volatility of Costs for North Carolina and Wisconsin Risk-sharing provisions limit costs and volatility for Wisconsin 30% North Carolina 30% Wisconsin 25% 25% 20% 20% 15% 15% 10% 10% 5% 5% 0% 25th Percentile (4.6%) 50th Percentile (6%) Expected (7.25%) 0% 25th Percentile (4.8%) 50th Percentile (6.6%) Expected (7.2%) Min Average Max Deterministic Note: 20-year projected contributions at different returns Sources: The Pew Charitable Trusts and the Terry Group 43

44 Greg Mennis pewtrusts.org/publicpensions Susan Banta pewtrusts.org/publicpensions pewtrusts.org